Capital Adequacy

The Capital Adequacy Ratio (CAR) is the primary metric used to quantify a financial institution's capital strength, calculated by dividing its total regulatory capital by its risk-weighted assets (RWA). The formula is expressed as: CAR = (Tier 1 Capital + Tier 2 Capital) / Risk-Weighted Assets. This ratio is the cornerstone of the international regulatory framework known as Basel III, developed by the Basel Committee on Banking Supervision (BCBS) in response to the 2007-2009 financial crisis to strengthen global banking standards. Basel III mandates specific minimum capital requirements to ensure banks can withstand severe economic and financial stress. Specifically, the framework requires a minimum Total Capital Ratio of 8.0%, which includes both Tier 1 and Tier 2 capital. Within this total, the minimum Tier 1 Capital Ratio must be 6.0%, and the highest quality component, the Common Equity Tier 1 (CET1) Capital Ratio, must be at least 4.5%. Furthermore, Basel III introduced a Capital Conservation Buffer (CCB) of an additional 2.5% of RWA, which must be met with CET1 capital. This means that to avoid restrictions on dividend payments and discretionary bonuses, a bank's effective minimum CET1 ratio is 7.0% (4.5% minimum + 2.5% buffer). The RWA calculation is crucial, as it assigns risk weights to different asset classes; for instance, a cash holding might have a 0% risk weight, while a corporate loan might have a 100% risk weight, and a mortgage might have a 35% risk weight. This risk-sensitive approach ensures that banks holding riskier assets must hold proportionally more capital. For example, consider a regional bank with $100 billion in total assets. If, after applying risk weights, its RWA is calculated to be $50 billion, it would need to hold a minimum of $4 billion in total capital (8% of $50 billion) to meet the basic Basel III requirement. If the bank only holds $3.5 billion, it is undercapitalized and faces severe regulatory action, including restrictions on its operations and growth. The CAR is thus a vital indicator of a bank's resilience, directly influencing its ability to lend, expand, and manage unexpected market volatility, which is particularly relevant for the stability of the entire financial ecosystem, including its fintech partners.